More inflation, monsieur?

The majority of family offices use inflation-adjusted performance measures to assess their investment returns. Inflation is a hot topic right now, and the dilemma that offices face is how to measure inflation rates, and how to assess the positive and negative impact of inflation on future wealth.

Official inflation rates, such as consumer price indexes (CPIs), are not a good place to start. These measures have become political tools. They are used for setting public sector spending budgets and debt ceilings, making interest rate decisions, and calculating inflation-linked state payments. When the published inflation rates give the “wrong results” (similar to unemployment rates), governments simply change the underlying methodologies.

For investors, the main problem with consumer price measures is that they don’t give a true and fair view of changes in asset values in specific asset classes, commodities and currencies. They don’t account for escalating prices in some areas, while prices in other areas are falling. They certainly don’t provide a good measure of a family office’s changing purchasing power, in the areas where family members are likely to spend in the future.

Another serious concern about inflation is the amount of new money that central banks are currently injecting into the financial system. Will this turn out like the famous Monty Python restaurant sketch, where the waiter serves his fat customer more and more food, until that final, fatal one little mint? Is this what is happening to our economies? Will we grow fatter and fatter on quantitative easing until we explode into hyper-inflation? It’s certainly one scenario that economists talk about, even if the actual result is more likely to be a mix of deflationary and inflationary pressures, something that will be exceptionally hard to hedge correctly.

Good or bad, inflation can have a big impact on your wealth and the prosperity of your children and future generations. If you are invested in the right assets, commodities and currencies, then inflation is a very good thing. Families who invested in high quality real estate, in the right locations, ten or fifteen years ago would probably have done a lot better than those who invested their money in conventional, index-tracking stock market investments. The same is true for investments in some high risk, high return business sectors. Few people call the tremendous growth in income and profits in successful sectors “hyper-inflationary”.

However, if you are invested in the wrong assets or if your businesses are margin sensitive and you rely on goods and services that are becoming more and more expensive, then you are in trouble. Equally, if you set aside a specific amount of money for the future and find that the money no longer gives you or your dependents the standard of living you expected, then inflation is bad news.

History suggests that it pays to take a long hard look at your inflation-adjusted expectations for future generations. Do you want them to have the same purchasing power as you have now? If so, what specific assets, commodities and currencies do you expect them to purchase? For example, if your young grand-children and other relations all want to live in nice houses in fifteen years time, how much should you set aside to help them do this? Looking back fifteen years ago, you’d probably have grossly underestimated the money required to buy a decent house in an up-market location today.

These are precisely the kind of calculations that families need to be making now. Using a measure of domestic supermarket shopping basket prices is not going to help. And any investment performance report that shows investment returns adjusted for such a simple measure of inflation as the CPI should be treated with a major grain of salt.